Subdivided land treated as capital gain

Last month, the tax court ruled on a case (TC Memo. 2009-142) involving the issue of a parcel of land that was subdivided and sold over a period of time. At stake was the issue of whether the taxpayers were required to pay ordinary income on the investment property versus being treated to a more preferential capital gains treatment. It has implications for those considering a 1031 exchange that face a similar issue.

The case involved a couple that had purchased a 14 acre parcel to build their primary residence. Prior to building, the couple decided they would prefer to have neighbors rather than being so remote. They made the decision to subdivide the former agricultural property into ten parcels.

Over the next four years, the couple went thru the re-zoning process, created a homeowners association and sold seven of the lots. When the couple reported the income as capital gain, the IRS claimed that, with the sale of multiple lots, their status had changed from investor to dealer and that all profit constituted ordinary income due.

Eseentially, because a) their advertising was nothing much more than a simple wooden sign, b) they sold the lots primarily to acquaintances and c) they were not considered real estate developers (having ownership in a non-development, successful business), the tax court held that the gain qualified for capital gains treatment.

The case provides insight with respect to 1031 exchanges as well. It, theoretically, follows that if the taxpayer had chosen to exchange into another qualifying real estate investment - rather than simply sell the lots and pay the capital gains tax - they could have deferred the gain under section 1031.

We are occasionally asked what qualifies as "held for" investment and what type of exchange does not qualify due to the taxpayer being viewed as a dealer (i.e. - developer) versus an investor.

The court laid out nine factors that determined the property status:

1. The taxpayer's purpose and reason for property acquisition.
2. The purpose for subsequently holding the property.
3. The taxpayer's everyday business.
4. The frequency and substantially of sales.
5. The extent of improvements.
6. The extensive use of advertising.
7. The existence of a business office for property sales.
8. The degree of supervision over sales agents.
9. The time habitually devoted to sales.

It would appear that a taxpayer that can meet the above factors, and considering a like kind exchange, could reasonably justify they are not a developer/dealer and qualify for deferred treatment under section 1031. While each case is different (and as we caution - the specific circumstances should be reviewed with a tax professional before proceeding), the case does provide some important insight into what might be possible.

Have a similar issue involving a 1031 exchange? Give 1031 Corporation a call at 888-367-1031. The phone call and conversation are free.